Tax

A history of taxing the rich – what might the future hold?

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Thanks to Panama and its papers, the rich and the tax they do (or don’t) pay is back at the top of the news agenda. Even before details of thousands of off-shore accounts/companies/investments emerged, the issue of what tax the rich should pay had recently returned to the centre of political debate for the first time since the 1980s.

In the UK we’ve seen a row about whether the top rate of tax should be 50 or 45 per cent generate more heat than any debate around much bigger tax rises or indeed cuts, while in the US Bernie Sanders wants to see a return to top tax rates nearing 55 per cent at the same time as Ted Cruz (the ‘moderate’ Republican extremist) argues for a flat rate of income tax set at just 10 per cent.

So this is a good time to discuss a new book – subtly entitled “Taxing the Rich” – from Kenneth Scheve of Stanford and David Stasavage of NYU. Riding the Piketty trend of political economy books with levels of data more common in academic journals, the volume navigates two centuries of history to explore when and why countries have chosen to tax the rich. Importantly this is not a narrow tax policy book, drawing as much on history and political theory as it does on econometrics. Mill and Dworkin are as central here as James Mirrlees.

So it’s a complex book – but one with a very simple conclusion: high rates of income (and inheritance) tax for the richest households seen across the middle part of the 20th century were not driven by the arrival of universal suffrage, left wing parties winning elections or a response to rising inequality. Instead they were the product of two World Wars that required mass mobilisations of populations to fight them, lending huge force to what Scheve and Stasavage call the “compensatory argument” for taxing the rich – the argument that tax policy should be used to compensate for wider unequal burden sharing or unjustified differences in outcomes between individuals for which the state bears responsibility. This strong manifestation of a compensatory argument was that, just as the state was requiring huge sacrifices of those conscripted to fight, so too the income and wealth of the nation should be conscripted to win the war and then in time to build the peace.

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Source: K Scheve & D Stasavage, Taxing the Rich: A History of Fiscal Fairness in the United States and Europe, Princeton University Press, 2016

Figure 1 shows the case of the UK and US economies with the top marginal rate of tax since 1900. The claim that these new forms of mass mobilisation war were associated with large increases in top rates of tax is clearly true. The top rate of tax in the UK was 8.33per cent in 1914 – but stood at 60per cent in 1920, a level that was inconceivable pre-war. A similar rise from 7per cent to 77per cent took place in the United States and in most other active combatants that mobilised on a similar scale.

The wars and their aftermath totally transformed politics and debates about what top tax rates should be. But they have not stayed there. The book goes on to note the significant decline in top tax rates world-wide since the 1970s. In explaining this decline the authors argue it was less to do with Reagan or Thatcher’s political genius, or indeed globalisation, and more to do with the weakening over time of war based arguments about equality of sacrifice. The left in many developed countries was left with woolly arguments about fairness which, lacking the power of strong compensatory arguments, were outgunned by the idea that people deserve to keep more of the reward for their hard work. The result was all marginal tax rates above 40 per cent being abolished in the UK in 1988, and similar reductions in the US.

We should note (and the book does) that there is a complex relationship between the top marginal rate of tax and whether the rich are actually paying less tax overall. In the UK, despite the big cuts in top tax rates, the share of total tax (direct and indirect) accounted for by the richest ten per cent of households has been on a steady upward trajectory – from 20 per cent in 1977 to around 27 per cent today (see the blue line in figure 2). Before we all start worrying about a stealth squeeze on the top, figure 2 also shows that this increase has been driven almost entirely by the fact that the top 10 per cent have also accounted for an increasing share of income. Indeed, as the red line shows, the importance of the richest 10 per cent to the Exchequer has increased even as the tax burden they face has actually fallen slightly to a fairly consistent 35% over the past 20 years.

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Source: RF analysis of ONS, Effect of Taxes and Benefits on Household Incomes

In its big picture argument the book is convincing, on both the correlation and nature of causality between wars that required the mass of working people to sacrifice not just their labour but also their lives, and the imposition of higher tax rates on the rich in the 20th century. But just as the strength of its argument comes from that big picture focus across the last century, so it leaves something to be desired for those of us trying to understand what is happening right now. Unless you’re expecting World War 3, the book doesn’t focus on what might drive more incremental changes in the tax that is paid by different groups in society today. And in the end those incremental changes are the main bread and butter of political debate – as the 50p tax debate in the UK has shown.

For example the book rather discounts the impact of the 1909 People’s Budget which saw the introduction of graduated supertax, with tax on the richest rising from 5per cent to 8per cent. A 60 per cent rise is a very big deal, and it followed big increases in Inheritance Tax in 1907. Understanding what leads to changes of that sort even in the absence of war is more directly relevant to the debates we face today.

Indeed the focus on the big picture of what leads to huge increases in top tax rates also leaves the book slightly understating what has occurred in recent years in the aftermath of the financial crisis, at least here in the UK. The authors are sceptical that similar structured arguments about equality of sacrifice can be used today because only a small fraction of the wealthy directly benefitted from state bail outs – arguing that “it is not clear why Silicon Valley should be taxed just because Wall Street was bailed out”.

They are clearly right that we are not in a situation remotely analogous to a major war, but they do understate the use of compensatory arguments today and level of the anti-elite mood post-recession. Remember the political centrality of “we’re all in it together”, the huge fall in living standards experienced since 2008, and the widespread view even before the Panama papers that the rich operate by another set of rules to the rest of us. It also does not quite match the experience in the UK of recent years. Yes some taxes have gone up that affect lower income families since 2008, especially VAT in 2011, but the balance of arguments and actually implemented tax rises has focused on taxes that affect the very richest. Not just a higher 50p top rate of tax, but big reductions in pensions tax relief for top earners, removal of personal allowances for those earning over £100,000, and a (now partially reversed) increase in capital gains tax.

As the chart shows, in contrast to the picture for the top ten per cent of households, the tax burden (focusing just on income tax this time) faced by the top one per cent of individual taxpayers has risen since the financial crisis in the UK. A flat effective tax rate of just under 35 per cent pre-crisis underwent a step change with the introduction of the 50p rate, with a subsequent partial reversal following the reduction to 45p. As a result, the top one per cent’s contribution to total income tax revenue continued rising post-crisis, even as their share of gross income fell slightly.

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Source: RF analysis of HMRC, Survey of Personal Incomes

Before we conclude that the British state has suddenly become very progressive though, remember that while the tax rises may have disproportionately affected the very very richest, tax cuts are overwhelmingly benefitting the top half of households. At the same time, significant benefit cuts are taking billions away from those on low and middle incomes. It’s definitely not progressive – but it probably doesn’t feel like that if you’re in the top 1 per cent.

Given that we’re not expecting World War 3 anytime soon, the question for the future is whether the tide is already turning on the forces that led to the incremental increase in taxes on the very richest in recent years. You might think the move from a 50p to 45p top rate shows this has already happened, but a strong counter argument is that we still have a 45p rate despite a clear wish by the party of government to cut it to 40p. Meanwhile in the Scottish elections currently underway plans from all major parties to slightly increase taxes on more expensive homes are centre stage. Arguments about the rich paying their fair share in the aftermath of the great recession don’t quite seem done and dusted to me – even if we’re thankfully not talking about rates of over 90 per cent anytime soon.

This blog originally appeared on Prospect magazine’s website